Investors often overlook SEC filings, and it is the job of the 10Q Detective to dig through businesses’ 8-K and 10-Q SEC filings, looking for financial statement ‘soft spots,'(depreciation policies, warranty reserves, and restructuring charges, etc.)that may materially impact Quality of Earnings.

Aesthetics of breast augmentation aside, the compensation package awarded to Levine illustrates—once again—two problems with executive pay practices: (i) linking pay to performance is often undermined when Boards set benchmarks that are too subjective and weaken the link between CEO pay and corporate performance; (ii) an imbalance still exists between company stock performance and CEO pay.

For fiscal year 2007, the Compensation Committee at Mentor adopted a performance-based annual incentive bonus plan (“AIB”), which provided the Committee with the flexibility to design a cash-based incentive compensation program to motivate and reward performance for the year for its executive officers.

The benchmark used to determine minimum, target and maximum levels was founded upon Mentor’s achievement of specified results with respect to corporate operating income, or COI, for that fiscal year. The 10Q Detective noted, however that the Committee was granted the oversight “to modify” those bonus target levels:

In making the determination of minimum, target and maximum levels, the Committee retains wide discretion to interpret the terms of the AIB plan and to interpret and determine whether COI objectives or an individual’s performance objectives have been met in any particular fiscal year. The Committee also retains the right to exclude extraordinary charges or other special circumstances in determining whether our COI objectives were met during any particular fiscal year.

In addition, the target level with respect to COI has been based on confidential internal performance goals. In other words, the Committee does not have to clarify what they consider best practices to outside shareholders!

Fiscal 2007 was a notable roller coaster of a ride for common stockholders. , Following the November 17, 2006, announcement that the FDA approved for sale the Company’s MemoryGel silicone gel-filled breast implants, the share price peaked on November 21, at an intra-day high of $53.95, up almost 23% year-to-date. This news was material, for implants account for 87% of product sales.

In fiscal 2007, net sales increased 13% to $302.0 million from $268.3 million in the prior year. Net sales of breast implant products for plastic and reconstructive surgery increased 13% to $262.6 million from $233.2 million in the prior year. However, the Company saw (only) overall growth in unit sales of breast implant products of approximately 6 percent.

Corporate operating income for the 12-months ended March 31, 2007, fell 5% to $65.6 million, due to higher SG&A, R&D, and asset impairment and restructuring charges.

The Board may also approve cash bonuses outside of the AIB plan. For example, the Committee may approve bonus awards in connection with an executive officer’s efforts and accomplishments with respect “to strategic initiatives and milestones, and such bonus awards may overlap with or be in addition to bonus awards under the AIB plan.”

In fiscal year 2007, the Committee approved two special cash bonus awards to Mr. Levine in the aggregate of $450,000: a payment of $200,000 to compensate him “for his contributions to the sale of a urology division” and $250,000 for “his leadership in multi-year efforts to obtain FDA approval of the silicone gel-filled breast implants.”

Are we missing something—or do not the foregoing fall under expected JOB DESCRIPTION?

The Board rewards Named Executive Officers with annual grants of stock options, shares of restricted stock, and Performance Stock Units (PSUs), the size of which took into consideration a number of performance metrics with respect to annual rewards, including cash flow, revenue and share-net. The objective was to align employee interests with those of other stockholders.

In fiscal 2007, cash flow from operations fell 30% to $68.9 million (from the prior year) and % Return on Assets and % Return on Equity fell 10 basis points and 670 basis points to 9.2% and 17.4%, respectively.

Irrespective of these non-performing metrics, the Board still saw fit to reward Mr. Levine with $1.93 million and $702,318 in stock grants and stock options, respectively.

Investors initially bid up the share price of Mentor on expectations that the Company’s ability to sell (higher-margin) silicone-gel implants in the U.S. for women who wanted breast augmentation would yield healthy revenue and share-net gains for Mentor. As that promise proved premature, the stock fell.

Despite the hasty retreat in market valuation, CEO Levine is still sitting in the catbird seat. At fiscal year-end March 31, 2007, he held exercisable options for 171,250 shares at exercise prices ranging from $19.01 to $37.70 per share. In addition, in fiscal 2007, Mr. Levine exercised 100,000 shares with an unrealized gain of $3.32 million (not reported in 2007 compensation).

In its 2007 Proxy Statement, the Board reiterated that the ultimate objective of its compensation program was to improve shareholder value. In the last year, the stock lost $515.0 million in value, and currently has a market capitalization of $1.63 billion. Looks like the Board failed at that objective, too.

The 10Q Detective believes that Mentor (which formerly sold penile implants!) has an attractive, aesthetic implant business model, especially if it can execute on selling more of the silicone implants. The silicone-gel implants, which supposedly feel more like natural tissue, sell for about $600 (twice as much as the saline-filled aesthetic devices). Unfortunately, management has yet to demonstrate its ability to reign in costs and sell in a competitive market.

Editor David J. Phillips does not hold a financial interest in Mentor Corp. The 10Q Detective has a Full Disclosure Policy.

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About Me

Prior to founding the 10Q Detective, I held equity analyst positions with three brokerage firms and published the investment newsletter e-Growth Profit Letter - dedicated to uncovering companies with innovative, proprietary technologies in a range of industries. My work has been published in The Dick Davis Digest, The Bull & Bear Financial Report, BusinessWeek, CBS Interactive, Forbes, Kiplingers Personal Finance, MSN Money, TheStreet.com, 24/7 Wall Street, The Wall St. Journal, The International Herald Tribune, and Investors Business Daily.
The 10Q Detective is recommended as a 'Must-Read' money blog in Kiplingers (Oct. 2006 & May 2008), Washington Post (May 2009); a 'Best of Financial Blog' by BusinessWeek (Feb. 2007 & April 2008),a 'Smart Stop' by The Journal of Accountancy (March 2008); 'Top 25' by Time magazine, a 'Top 50 Money Blog' by CurrencyTrading.net (April 2008); and, a 2011 LexisNexis Business Law Blog Nominee.